MA2739-Curbing collateral concerns.indd - Euroclear

“Is is now possible to

“Is is now possible to search and manage virtually all client asset positions and, via the Collateral Highway, move the right collateral to the right collateral taker.” Saheed Awan, Global Head of Collateral Management Services, Euroclear Risk has become one of those words which provoke strong reactions from most people in today’s financial markets. Is risk really so bad that it should be avoided by market professionals, or should it remain part of our financial vocabulary when managed under the right conditions? Central banks and central counterparties (CCPs) have long been masters of risk management, as the core to their existence and ability to provide market support is all about the management of risks. The use of collateral to mitigate exposures is paramount to their success in contributing to the stability of the financial system. At times of financial stress, central banks traditionally have been prepared to lend against a wider range of collateral, and this time around it is no different. As critical sources of liquidity, central banks have three basic tools with which they can manage the risks associated with the collateral they take: • eligibility – what collateral the central bank will lend against • valuations – how much the collateral is worth • haircuts – how much the central bank will lend relative to the value of the collateral Collateral risk management plays a central role in ensuring the effectiveness of the central bank’s liquidity insurance operations. Accessing central bank credit As a case in point, the European Central bank (ECB) recently refused to accept Greek government debt as collateral in exchange for central bank funds. In addition, the ECB recently cancelled the second phase of its Correspondent Central Banking Model (CCBM2) project to focus first on other challenges. This means that we will likely see increased demand for triparty collateral management services to mobilise collateral to access central bank credit. PART OF THE COLLATERAL HIGHWAY Similarly, the collateral accepted by CCP clearing members is a key element in the mitigation of counterparty credit risk. The CCP’s collateral policy identifies the collateral types which are to be used for default fund contributions. Thereafter, the CCP monitors collateral PART OF THE COLLATERAL concentrations at member level and uses highly sophisticated quantitative methodologies to estimate the haircuts applied to the collateral accepted. HIGHWAY PART OF THE COLLATERAL HIGHWAY The same is true for interbank transactions, where collateral is now an imperative to mitigate risks in repos, secured loans and securities lending transactions, for example, which is why triparty collateral management is increasing in importance. Looking ahead, the mandatory clearing of OTC derivatives transactions as a result of new regulation, particularly EMIR in Europe and Dodd-Frank in the USA, will put even more pressure on the financial community to source eligible collateral to reduce the risks inherent The right in derivatives securities transactions. The right securities at the right place at the right place at the right time at the right time 2 Curbingcollateralconcerns

The collateral challenge As a result of all these trends, competition for collateral will become fierce, which is why collateral givers across the globe are searching for an efficient and effective way to better manage their assets for optimal collateral usage. On the other hand, collateral takers like central banks and CCPs will find it increasingly challenging to manage the collateral they receive. Given the amounts at stake, the allocation and management of collateral directed to central banks and CCPs will become systemic in nature, requiring a solid and scalable structural backbone. We believe the natural solution is for collateral, in its many forms, to be collected centrally and then segregated within central securities depositories (CSDs). Others seem to share this belief as a number of global custodians are thinking about establishing a CSD for this purpose. Moreover, the scarcity of quality collateral, the increasingly global nature of clearing for an expanding range of transactions and the international reach of most banks and financial institutions means that there will be a powerful need for cross-regional access to collateral. Thus, the sourced and collected collateral will need to be mobilised and optimised across locations and time zones to satisfy various collateral requirements. Euroclear is embarking on a mission to create the first fully open global market infrastructure to source and mobilise collateral across borders. Called the ‘Collateral Highway’, it is helping market participants move securities from wherever they are held to serve as collateral wherever it is needed. Open Inventory Sourcing technology Financial institutions keep securities collateral in various locations for many good reasons. Thus, securities to be used as collateral are often ‘locked’ in a particular market, entity or time zone, reducing collateral management efficiency and securities optimisation for cross-border collateral purposes. As part of its mission, Euroclear has developed Open Inventory Sourcing technology to keep track of the collateral positions deposited by clients in various locations. Euroclear’s conventional triparty collateral management system sourced securities for collateral held only in Euroclear Bank. It is now possible to search and manage virtually all client asset positions and, via the Collateral Highway, automatically move the right collateral to the right collateral taker. Euroclear will also monitor, value and substitute securities used as collateral when and if needed during the lifecycle of the transaction, and return the securities to the original place of deposit when they are no longer needed. As important, when collateral is sourced and does not meet the collateral eligibility Euroclear’s global Collateral Highway criteria of the collateral taker, ineligible collateral may be transformed into eligible collateral by swapping collateral on the Collateral Highway. This is a real problem, according to CCP clearing members, in that many derivatives users, such as pension funds or mutual funds, will not have enough eligible collateral to satisfy future collateral taker requirements. Morgan Stanley and Oliver Wyman estimate that more than $500-800 billion of additional collateral will be needed to clear over-the-counter (OTC) derivatives trades by CCPs in the coming years. Euroclear’s role in the Collateral Highway is a natural one. With links to about 45 CSDs, its future connectivity to TARGET2- Securities and existing relationships with over 90 central banks and CCPs, it can easily organise domestic and cross-border collateral flows for the industry. As the Collateral Highway provides seamless access to CCPs and central banks, it reduces – if not eliminates – the need for banks to establish their own CSD. Moreover, proprietary collateral management services offered by banks can easily interoperate with the Collateral Highway. >> Curbingcollateralconcerns 3